Monday, March 17, 2014

David Malpass' recent op-ed in the WSJ ("The Fed's Taper Is Already Paying Off") highlights what is arguably the biggest and most recent development in the U.S. economy: the sharp increase in bank lending to small and medium-sized businesses that began around the time the Fed started to taper its bond purchases in early January. I think there's more to the story than just tapering, and if I'm right it means that the Fed ought to accelerate its tapering, since that would probably work to the economy's benefit, in addition to lessening the risk of an unpleasant rise in inflation.

The first chart above shows the level of C&I Loans outstanding (the most recent available data being March 5th), while the second chart shows the 3-mo. annualized rate of C&I Loan growth. Loans didn't really start to pick up until the second half of January, and since then they have expanded at a blistering 36.2% annualized rate. We have rarely seen such rapid growth in C&I Loans, so we can be reasonably sure that something big is happening. As David suggests, it is likely no coincidence that banks began stepping up the pace of their lending to the private sector shortly after the Fed started borrowing less from the banking system in early January. But is that the whole story? I doubt it.

As David explains it, now that banks are lending less to the Fed each month they have more money available to lend to the private sector, and this is why loan volume is accelerating. But there's another possible explanation: banks are lending more because they want to, and because the private sector is now more eager and/or less reluctant to borrow. Both of these developments—more willingness to lend, plus more willingness to borrow—could be coming together in a perfect storm that could result in a significant decline in money demand and an increase in money supply. That's the stuff of which higher inflation is made.

All of the money that banks have been lending to the Fed since 2008 has come, on balance, from a strong net inflow of savings deposits (see charts above). Banks essentially functioned as intermediaries, funneling a flood of savings deposits to the Fed in exchange for bank reserves. As evidence, I note that bank reserves have increased by $2.62 trillion since September 2008, thanks to the Fed's bond purchases, while bank savings deposits have increased by $3.15 trillion. At the risk of over-simplying what happened, since 2008 banks have taken in trillions of savings deposits, used the money to buy bonds, and then sold those bonds to the Fed in exchange for bank reserves. There was nothing untoward about any of this, from a monetary perspective, because inflation has remained low and relatively stable for the past several years.

As I began explaining one year ago, the Fed has effectively been borrowing money from the banking system in exchange for newly-minted bank reserves, which (very importantly) are not money but rather short-term, T-bill equivalent assets. This, David argues, has resulted in a mis-allocation of credit (from banks to the federal government), and that has worked to slow the economy, since the government has not used that credit as productively as the private sector could have. So, he goes on, as less of this happens (i.e., as the Fed continues to taper) the economy will benefit. That makes sense to me.

But I see other things going on. By tapering its QE purchases, the Fed is reacting to a decline in the banking system's demand for bank reserves, because the growth of savings deposits has been decelerating for the past two years. In fact, in the past three months savings deposits at U.S. banks have only grown at a mere 1.4% annualized pace, and they have not grown at all since the Fed started tapering its QE purchases in early January. For most of the past several years, the Fed's QE bond purchases served mainly to accommodate the public's seemingly insatiable demand for safe, short-term savings deposits. That's changed significantly in the past few months, however. The private sector is no longer so risk-averse, and banks are apparently also less risk-averse; that would explain why loan volume is expanding and savings deposit inflows have come to a virtual halt. The slowdown in deposit growth and the increase in bank lending are both signs of a return of confidence. The return of confidence is the Fed's worst nightmare.

When confidence was low, and when households wanted to deleverage and boost their holdings of safe, short-term deposits, banks happily lent their deposit inflows to the Fed in exchange for bank reserves because they were averse to taking on the extra risk of lending to the private sector. But now, even though the Fed is buying $65 billion a month instead of the $85 billion per month it did beginning September, 2012, the Fed is beginning to compete with the private sector for credit: QE purchases are far in excess of savings deposit inflows. Until recently, banks had it easy—they simply lent their deposit inflows to the Fed. Now, in order to sell $65 billion of bonds to the Fed every month (though that is likely to soon fall to $55 billion per month, as the FOMC is likely to announce on March 19th), banks are going to have to scrounge up the money from other sources in order to buy the bonds the Fed wants to buy from them. Banks might even consider expanding their lending (actually, they already have), since they have enough reserves to back up an almost unlimited volume of loans. More lending equals more money creation (only banks can create "money") and more deposits, and those deposits can be used to buy bonds to sell to the Fed.

So there are more big things going on than simple tapering—which has only reduced the amount of bonds the Fed buys monthly from $85 billion to $65 billion. The big, unreported news is that the public's appetite for safe-haven assets and deposits has been diminishing at a much faster pace than the tapering of QE.

Until recently, banks have not been utilizing their bounty of bank reserves to fuel an explosion in lending because they have been very risk-averse. Since late 2008, they have preferred to lend their deposit inflows to the Fed, even though they pay only 0.25%. Not only have banks been reluctant to lend to the private sector, but the private sector has been very reluctant to borrow—households' leverage has declined significantly in the past four years, as the chart below shows. According to the Fed's Flow of Funds data, household liabilities haven't grown at all for the past several years, even as incomes and jobs have increased. And as one of the charts above shows, bank lending to small and medium-sized businesses has only recently increased from pre-recession levels.

Fed tapering is still relatively new news, but confidence has been slowly returning for quite some time, as evidenced by the fact that over the past few years the growth in savings deposits has been slowing, gold has fallen from $1900 to $1370/oz., bank lending has picked up, consumer confidence is slowly rising, demand for safe assets is declining, credit spreads are tightening, and PE multiples are expanding. The Fed is tapering at the same time banks are becoming less willing to lend to the Fed and more willing to lend to the private sector, but the Fed is in a reactive, rather than a proactive mode these days. If they don't step up the pace of tapering, they run the risk of creating a situation in which the demand for money falls faster (in the form or rising loan demand and slowing or falling savings deposit growth) than the Fed's willingness to supply money to the banking system (indirectly via the provision of bank reserves). And that would be like deja vu all over again, since that is what caused the rising inflation of the 1970s.

The Fed could avoid this problem or minimize this risk by increasing the pace of its tapering and/or increasing the interest rate it pays on bank reserves. Either development would be welcome, in my view.

10 comments:

I guess I am the last man on Earth who think the Fed should continue with QE.

So far, QE has coincided with economic recovery and very low inflation rates. Now we are at 1 percent on the PCE deflator, about half the Fed's target. Europe at 0.7 percent, and Japan caught near zero.

Rarely mentioned by anyone is that we have deleveraged American taxpayers by about $3 trillion. That may have to be reversed, but maybe not. The Fed can just maintain its bond hoard, if circumstances permit.

We have actually seen record low rates of inflation during QE. That was the same thing that happened in Japan 2002-06, when they conducted a successful QE program. (John Taylor called it a success).

I don't savvy the idea that banks are "lending money to the Fed" by any definition..

Okay, under QE the Fed "prints money" and buys bonds. The bondholders sell to the Fed, and then they can spend the money, invest the money, or bank it.

If bond sellers bank the money they get from the Fed, the banked money can be lent out, or stuffed into reserves.

How this is "banks lending money to the Fed" escapes me.

I do see the mechanism this way: The Fed prints money and buy bonds, and bondholders spend some (stimulating the economy), invest some (good), and put some into the banks. Other depositors are also putting money into banks, as safe harbor.

There is an element of disintermediation in what the banks are doing. They are not lending out all of their excess reserves. The get 0.25 percent interest on excess reserves, perhaps a bad idea. But then banks and central bank are tight. It is like asking the USDA to develop farm policies.

In America we have federal deposit insurance. That encourages people to go to banks for safe harbor, and liquidity. (People who say they believe in free markets might feel differently once you mention eliminating FDIC). Americans have poured money into deposits, as Scott Grannis has shown

Anyway, C&I loans have been rising nicely (as Scott Grannis has done a superb job pointing out) all through QE. Now we are supposed to believe that mild tapering is adding an extra fillip? The Fed is still creating money and buying bonds.

I agree with Scott Grannis the continuing rise in C&I lending is only good news. I rather suspect it is happening in part for a reason Scott Grannis does not mention, and that is rising real estate values.

As a small warehouse owner in Los Angeles, and business guy, in general the only time I could get a loan was on my property. Property as collateral. Even the SBA really won't lend on much else.

So, we have had a recovery in real estate values, and that means business guys can borrow more money.

Try asking a bank for a loan--they want collateral.

Now businesses have collateral. This could be a virtuous cycle, although I would like to see the USA rely less on debt and more on equity. But that is another post....

The idea that the Fed buying bonds is closely linked to growth of excess reserves at the Fed, is a simple and clear explanation of the minimal consequence of QE. QE buys bonds with the increase in reserves of banks (which is money that normally is put in short term bonds).

The bigger consequence of QE may be to confuse the free markets and discourage lending with banks waiting out the affect.

I suspect that a great number of market participants and observers do not fully understand how QE works. The myth that QE means the Fed is "printing money" persists. All the Fed can do is buy bonds from banks and "pay" for them by crediting the banks' reserve account at the Fed. This is equivalent to the banks selling bonds to the Fed and simultaneously lending the money to buy them. It is also equivalent to the Fed acting like a massive hedge fund, borrowing money at a short-term interest rate (0.25%) that it sets in order to buy notes and bonds. It is also equivalent to the Fed "transmogrifying" notes and bonds into T-bill substitutes. No money creation is involved in the QE process. Money is only created if banks use their reserves to back up an increase in lending. Banks have only recently started to do this in earnest.

The second chart is based on the same data series as my charst. The only difference is that your charts show the year over year change, whereas my second chart shows the quarterly annualized rate of change. My first chart shows only the level of loans outstanding